Basics of Bonds A bond is simply a negotiable IOU or a loan. Investors who buy bonds are lending a specific sum of money (the principal) to the bond issuer - a corporation, a government, or some other borrowing institution - for a specified period of time (the term). Typically, the bond issuer promises to make regular payments of interest to the investor at a rate that is set when the bond is issued. This is why bonds are often referred to as fixed-income investments. The term of a bond ends on the bond's maturity date, at which time the issuer repays to the investor the face amount listed on the bond. When a bond is held to maturity, its face amount is repaid in full. Before maturity, however, the value of a bond may often fluctuate. These continual changes in bond prices are influenced by many factors, including interest rate movements, supply and demand, changes in the financial health of bond issuers, returns offered by other investments, and the maturity date of a bond. Types of Bonds Bonds can have considerable variations in maturity, and they may have a wide range of credit ratings. Bonds are issued by the federal government and its agencies, state and local governments, and corporations. U.S. Treasury Securities offered by the U.S. Treasury come in three forms: U.S. Treasury bills, which have maturities ranging from 90 days to 1 year. U.S. Treasury notes, which have maturities from 1 to 10 years. U.S. Treasury bonds, which have maturities from 10 to 30 years. Treasury securities are considered the safest of all debt instruments because they are legally backed by the full faith and credit of the U.S. government. This designation, which is the highest level of backing given on a U.S. government security, means that the government pledges to use its full taxing and borrowing authority, as well as revenue from nontax sources, to pay the interest and repay the face amount of the security. Nonetheless, the market prices of these securities are not guaranteed and will fluctuate daily just like the prices of any other bonds. Interest paid on Treasury bonds usually is exempt from state and local income taxes, but is not exempt from federal income taxes. U.S. Government Agency U.S. government agency bonds and securities are issued by agencies that are owned, backed, or sponsored by the U.S. government. While some of those bonds and securities are backed by the full faith and credit of the government, others carry less formal guarantees. The most common agency securities are mortgage pass-through securities such as those issued by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac). Mortgage pass-through securities are backed by home mortgage loans. By purchasing mortgage pass-through securities, investors are making mortgage loans to homeowners through intermediary companies. Homeowners make monthly mortgage payments to mortgage-servicing companies, and those payments flow through to investors holding the mortgage pass-through security. Of these agencies, only Ginnie Mae offers securities that are backed by the full faith and credit of the U.S. government. Nonetheless, bond market professionals believe that all of these securities have a very high credit quality, meaning that the issuing agency is very likely to pay the bond's interest and principal in full and on time. Indeed, these agency securities are regarded as equal or even superior to bonds issued by the most creditworthy corporate borrowers. Other U.S. government agencies also issue securities, and investors should carefully investigate the level of backing provided by the U.S. Treasury for those investments. Corporate Bonds Corporate bonds are issued by companies of varying quality and in various maturities from short-term (between 1 and 5 years) to intermediate-term (between 5 and 10 years) to long-term (more than 10 years). Most corporate bonds are assigned a letter-coded rating by independent bond-rating agencies such as Moody's Investors Service, Inc., and Standard & Poor's Corporation to indicate their relative credit quality - the likelihood that the issuer will pay interest and principal in full and on time. Investment-grade bonds are issued by well-regarded companies and rated as desirable investments. To be considered investment-grade, a bond must be rated BBB or better by Standard & Poor's, or Baa or better by Moody's. Corporate bonds with a lower rating or no rating are sometimes called high-yield bonds because of the higher interest rates they must pay to attract investors. They are also sometimes referred to as junk bonds because the issuers are believed more likely to default that is, to fail to make full interest and principal payments as scheduled. Municipal Bonds Municipal bonds are issued by state and local governments to support their financial needs or to finance public projects. Interest paid on municipal bonds is typically exempt from federal income taxes and, in some cases, from state and local taxes too. (However, capital gains earned on a municipal bond investment like capital gains on any security are subject to federal and, possibly, state and local income taxes as well.) Like corporate bonds, municipal bonds come with a variety of ratings to reflect the fact that some state and local governments are financially stronger than others. Municipal bonds, which have maturities ranging from less than 1 year to 40 years, are also known as tax-exempt, or tax-free, bonds.